Price discrimination

This article describes a pricing strategy used by sellers, typically in markets that suffer from imperfect competition, significant transaction costs or imperfect information.
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Definition

Price discrimination is the practice of a single seller selling identical goods (identical in terms of production costs) at different prices to different buyers.

Price discrimination is counter to the law of one price.

Motivation behind price discrimination

Price discrimination practiced for profit

Further information: Price discrimination practiced for profit

Price discrimination is profitable in situations where different consumers have different demand curves for the same product. Here is a simple illustrative example that assumes a single yes/no decision for purchase rather than a decision on volume.

Suppose a seller produces a good at a price of $5$ money units, and there is no competition. Buyer $A$ is willing to pay $10$ units for the good, and buyer $B$ is willing to pay $30$ units for the good.

The situation without price discrimination:

If the seller has to choose a single price, the seller has the option of pricing the good at $10$ units, in which case both $A$ and $B$ buy the good.

The producer surplus in this case is $2(10-5)=10$.

The consumer surplus in this case is $0$ for $A$ and $30-10=20$ for $B$. The total consumer surplus is $20$ units. The total of producer surplus and consumer surplus is $30$ units.

On the other hand, if the seller prices the good at $30$ units, buyer $A$ does not buy, while buyer $B$ buys one unit. Here, the consumer surplus is zero, while the producer surplus is $30-5=25$. The total surplus is $25$ units. Here, the producer surplus is more, but the consumer surplus is less, and the total surplus suffers.

The prices of $10$ and $30$ chosen by the seller are both local maxima in terms of producer surplus. Further, the price of $10$ is also a maximum in terms of the total social surplus, and the price of $30$ is a maximum in terms of the producer surplus alone.

The situation with price discrimination:

Now, the seller sells to $A$ at a price of $10$ and to $B$ at a price of $30$. The total consumer surplus is zero, because each buyer is being charged to the maximum, whereas the producer surplus is $(10-5)+(30-5)=30$ units. Note that the total social surplus is the same as in the situation of a uniform price of $10$, but now, all the surplus is captured by the seller.

The situation with competition:

In a market with perfect competition among sellers, the price is bid down to very close to $5$ units. The total social surplus is $30$ units, but this time, all the social surplus is captured by the buyers.

Price discrimination practiced for other reasons

Government-owned enterprises may practice price discrimination in order to meet social goals or to satisfy the political demands of voters.

Conditions for price discrimination

The main problem with price discrimination strategies is the leakage of the low-price product to customers who might have been willing to pay the higher price.

Market power

Further information: Price discrimination requires market power

For a seller to practice price discrimination, i.e., to price the same good differently to different buyers, the seller must have at least some market power. For instance, if a seller has both a low price for some buyers and a high price for other buyers, another seller can come along and offer the same good at a medium price for all buyers. The other seller is thus able to steal the most profitable customers from the original seller, forcing the original seller to lower prices. In this manner, a competitive market erodes price discrimination.

Preventing high-price buyers from choosing low-price alternatives

Price discrimination requires strategies to prevent customers in the high-price segment form choosing the low-price version. The strategies are of two kinds:

• Requiring certain eligibility conditions to qualify for the low-price product. The eligibility criteria may include geographic location (lower prices in developing and backward areas), time, or demographic characteristics of the buyer (for instance, student discount cards, senior citizen discount cards, clipper coupons).
• Requiring customers to put in extra work to obtain the low-price product: This includes methods for arranging items in supermarkets so that price-insensitive customers are likely to pick the high-price versions while bargain shoppers are likely to pick the low-price versions.
• Deliberately sabotaging low-price products at added cost to prevent people willing to pay a higher price from switching to the lower price: This is observed in knowledge goods. Further information: Price discrimination for knowledge goods
• Using marketing techniques to make high price payers believe that the high-price product is different or superior.

Difficult to resell

If it is easy for people to resell goods obtained at the low price to buyers willing to pay the higher price, price discrimination is difficult to maintain.

Alternative explanations for apparent price discrimination

If price discrimination seems to be occurring, but the conditions necessary for successful price discrimination are not satisfied, there are likely to be alternative explanations. Alternative explanations to price discrimination usually hinge on hidden costs, such as opportunity costs, greater expectations of customers paying higher prices, and non-obvious differences in quality. Here are some examples:

• Greater price as a proxy for costs of time, space, or other options that are not directly charged for: For instance, food and drink items that are typically ordered by customers seeking to stay for long may be charged higher, to compensate for the time spent occupying the table.
• Greater price for clients who are likely to be more demanding: Buyers who are more likely to demand better goods and service, or place other additional demands on the sellers, may be charged more to compensate.

Costs and benefits of price discrimination

Price discrimination indicates the existence of sellers with market power, and this is bad news because sellers with market power may set prices and quantities to maximize their own surplus in a way that does not maximize the social surplus. However, the price discrimination itself may well be better than the other options for a seller with market power.

Price discrimination is good when it expands available markets

Further information: Price discrimination is efficient when expanding available markets

Consider the example of a seller (with no competition) whose product cost per unit of a good is $5$ units, and two buyers $A$ and $B$, who value the good at $10$ and $30$ units respectively.

In the absence of price discrimination: The seller sets a price of $30$ units. Buyer $A$ does not buy, while buyer $B$ buys. The seller has a producer surplus of $25$ units.

For the seller, this is preferable to selling at a price of $10$ units or less, because at that price, the seller's profits are limited to $2(10-5)=10$.

In the presence of price discrimination: The seller sets a price of $30$ units for buyer $B$ and $10$ units for buyer $B$. The producer surplus is now $25$ units for buyer $B$ and $5$ units for buyer $A$. There is no consumer surplus. The total social surplus is $30$ units, which is the maximum possible.

Thus, price discrimination increases the total social surplus generated. In this situation, price discrimination is preferable for society to the alternative single high price. Nonetheless, it is not preferable to a situation of perfect competition. Perfect competition not only maximizes social surplus but also gives consumers a larger fraction of it.

Price discrimination is inefficient when it redistributes resources among existing buyers

Further information: Price discrimination is inefficient when distributing limited resources

Price discrimination can be bad when it distributes limited resources from people who value them more (indicated by a willingness to pay more) to people who value them less. Examples are discounts for certain groups for seats in flights and trains. Such discounts may end up allowing people who derive relatively less benefit from traveling to travel in place of others who may have benefited more.